IND-AS: Liability Or Equity?

Published on Tue, May 05,2015 | 17:04, Updated at Wed, May 06 at 12:25Source : Moneycontrol.com

By: Vishal Bansal, EY member firm

Classification of a financial instrument into equity and liability by the issuer is very important to present true and fair view of financial statements. A financial instrument classified as equity creates an ownership interest in a company, remunerated by dividends, which is accounted for as a distribution of retained profit. Liabilities, such as loan finance, on the other hand, are remunerated by interest, which is charged to profit or loss (P&L) as an expense. Any misclassification will affect decision-making of stakeholders such as investors, bankers, lenders and taxation authorities.

Under Indian GAAP, no notified accounting standard prescribes distinction between equity and liabilities. Essentially, classification and accounting for liability and equity is dictated by the legal form of the instrument.

In economic terms, however, distinction between share and loan capital can be far less clear-cut than the legal categorisation suggests. For example, a redeemable preference share could be considered to be, in substance, much more like a liability than equity. Conversely, many would argue that a bond which can never be repaid but which will be mandatorily converted into ordinary shares deserves to be thought of as being more in the nature of equity than of debt, even before conversion has occurred.

Under Ind-AS, Ind-AS 32 Financial Instruments: Presentation establishes principles for presenting financial instruments as liabilities or equity. Under the standard, key feature determining a financial instrument as a liability is the existence of a contractual obligation of one party (the issuer) to deliver cash or another financial assets to another party (the holder), or to exchange financial assets or liabilities under conditions that are potentially unfavourable. In contrast, in the case of an equity instrument the right to receive cash in the form of dividends or other distributions is at the issuer’s discretion and as such no obligation to deliver cash or another financial asset to the holder of the instrument exists. Financial instrument classified as liability will normally have features like presence of maturity date and mandatory redemption of the instrument. Equity instrument will normally have features like absence of maturity date, discretionary cash flows and/ or economic compulsion (where there is no contractual obligation) to make dividend payments.

Hence, under Ind-AS 32, the substance of a financial instrument, rather than its legal form, governs its classification in the issuer’s balance sheet. Substance and legal form are commonly consistent, but not always. Some financial instruments take the legal form of equity but are liabilities in substance and others may combine features associated with equity instruments and features associated with financial liabilities. For example, a preference share that provides for mandatory redemption by the issuer for a fixed or determinable amount at a fixed or determinable future date, or gives the holder the right to require the issuer to redeem the instrument at or after a particular date for a fixed or determinable amount, is a financial liability.

Broadly speaking, an instrument can generally be classified as equity under Ind-AS 32 if and only if:

The issuer has an unconditional right to avoid delivering cash or another financial instrument, or

If it is settled through own equity instruments, it is for an exchange of a fixed amount of cash for a fixed number of the entity's own equity instruments.

In all other cases it would be classified as a financial liability.

The following table summarizes classification of various financial instruments by an issuer under Ind-AS 32:

Type of financial instrument

Impact

Share Application money pending allotment

If company is going to issue fixed number of shares and does not have any obligation to refund the application money, it should be classified as equity. If these conditions are not satisfied then same will be classified as liability.

Non-convertible debentures

No impact on classification as liability. However, subsequent measurement will be at amortised cost and interest will be recognized as per effective interest rate method.

Optionally convertible debentures (in Indian Rupees)

Compound financial instrument (discussed below) and hence split accounting to be followed. The company will have to recognize the issuer’s obligation to pay interest and potentially, to redeem the bond in cash (financial liability) and right to call for shares of the issuer i.e. put option available to the debenture-holder (equity) separately.

Financial liability since it provides mandatory redemption by the issuer for a fixed or determinable amount at a fixed future date. Also, dividend/ interest is mandatorily payable at market rate.

Zero Coupon Bonds (to be repaid by way of conversion to fixed number of equity shares)

Equity instrument

Zero Coupon Bonds (to be repaid by way of conversion to variable number of equity shares whose value equals the redemption amount)

Financial liability

Contribution from unit holders in mutual funds

Based on general principles of Ind-AS 32, this may have been classified as a financial liability. However, Ind-AS 32 contains special exception rules for puttable instruments. If criteria in exception rules are met, these will be classified as equity.

Compound financial instruments

Many financial instruments are structured such that they contain both equity and liability components (i.e., the instrument is neither entirely a liability, nor entirely an equity instrument). Such instruments are defined in Ind-AS 32 as compound financial instrument. An example of ‘compound financial instrument’ is a bond convertible into a fixed number of equity instruments which effectively comprises of:

A financial liability (the issuer’s obligation to pay interest and, potentially, to redeem the bond in cash), and

An equity instrument (the holder’s right to call for shares of the issuer).

Ind-AS 32 requires the issuer to identify these elements and disclose the same accordingly. Following example explains how equity and liability components in a convertible debenture are identified at initial recognition which is normally referred to as ‘Split Accounting’.

Example

ABC Limited (ABC) entity issues 2,000 convertible debentures at the start of year 1. The debentures have a three-year term, and are issued at par with a face value of INR 1,000 per debenture, giving total proceeds of INR 2,000,000. Interest is payable annually in arrears at a nominal annual interest rate of 6%. Each debenture may be convertible at any time up to maturity into 250 equity shares by the debenture holder. If the debenture holder does not exercise the option till maturity date, the company will redeem the debentures in cash. When the debentures are issued, the prevailing market interest rate for similar debt without conversion option is 9%.

Application of requirement

The liability component is measured first and the difference between the proceeds of the debenture issue and the fair value of the liability, generally referred to as the residual value, is assigned to the equity component. The present value of the liability component is calculated using a discount rate of 9 %, the market interest rate for similar debentures having no conversion rights, as shown below:

Identification of components

Carrying value

Liability component

INR

Present value of the principal

INR 2,000,000 payable at the end of three years @9%

15,44,367

Present value of the interest INR1,20,000, payable annually in arrears for three years @9%

303,755

18,48,122

Equity component (Balancing Figure)

1,51,878

Proceeds of the debenture issue

20,00,000

The financial liability component will be subsequently measured at amortised cost in accordance with the measurement requirements of Ind AS 109 and interest expense will be recognised using an effective interest rate of 9% per annum. The equity component will not be re-measured.

Accounting for Foreign Currency Convertible Bonds (FCCBs)

Many Indian companies have used FCCBs to raise finance for their operations. The current Indian GAAP does not contain any specific accounting treatment for FCCBs. A perusal of financial statements of few Indian companies indicates that FCCBs are generally recognized at face value and interest expense is recognized as per the stated coupon rate, if any. Certain companies amortize premium payable on redemption over the period of FCCBs, while others treat the same as a contingent liability. Except a few cases, the premium is charged to the securities premium account as allowed under the applicable Companies Act. Thus, the premium does not impact P&L.

Under Ind-AS 32, FCCBs will be treated as compound financial instruments, requiring split accounting. The interest on liability component is recognised using the effective interest rate (EIR). Since determination of EIR also considers premium on redemption, the said premium is also charged to P&L and cannot be adjusted against the securities premium.

Interest, dividend, losses and gains

Classification of a financial instrument as a financial liability or an equity instrument determines whether interest, dividends, losses and gains relating to that instrument are recognised as expense or income in the statement of profit and loss or are recognised directly in the reserves and surplus. Thus, dividend payments on shares wholly recognised as liabilities are recognised as expenses in the same way as interest on a bond/ debenture. Similarly, gains and losses associated with redemptions or refinancing of financial liabilities are recognised in profit or loss, whereas redemptions or refinancing of the equity instruments are recognised as changes in equity.

Key impact

The accounting classification of an instrument as a liability or equity is much more than an accounting matter or matter of presentation in the financial statements. Particularly, it may have significant impact on reported financial performance of an entity. For instance, if an instrument needs to be classified as liability instead of equity, any return payable thereon will be charged to profit or loss as expense, instead of distribution of profit. Also, such change in classification will impact key performance indicators such as debt-equity ratio, interest coverage ratio, debt service ratio and earnings per share. This in turn may impact decision making of stakeholders like financial institutions, banks, equity holders and tax authorities. It could also result in violation of debt covenants, and could affect other amounts such as the number or stock options to be granted or managerial remuneration to be paid.

It is not necessary that Ind-AS 32 will have only negative impact. Depending on the situation of each company and the nature of instruments issued, impact could either be positive or negative. For example, certain reputed companies have issued perpetual bonds to raise long-term finance. As the name suggests, these bonds do not have any fixed maturity. These bonds therefore give a comfort of equity to the issuer. At the same time, the issuer, at its discretion, may redeem these bonds at a later date. While these bonds do not have any legal or contractual obligation for redemption; there are typically economic compulsions to redeem the same. Based on the exact legal and contractual terms of perpetual bonds, it may be possible to conclude that these bonds are not liability for the issuer; rather, they are part of equity under Ind-AS. If so, the issuer will treat interest payable on these bonds as the distribution of profit and debit the same directly to equity. From business perspective, an issuer may expect the following key advantages:

(a) If perpetual bonds are junior to bank loans, bankers may not reduce interest payable on the same, while calculating the interest service coverage ratio. This will help companies to improve their interest service coverage and other key performance ratios.

Interestingly, from a tax perspective, some tax advisors may argue that perpetual bonds are issued as bonds or debentures and hence result in a debtor–creditor relationship. Merely classifying them under the head “Shareholders’ funds” in the financial statements and showing the interest payments below the line in profit or loss (akin to dividend to equity holders) should not deprive the company of claiming these coupon payments for tax deduction. Nevertheless, these matters are debatable.